Economics
Credit Derivatives
Credit derivatives are financial instruments that allow investors to manage credit risk. They are contracts whose value is derived from the performance of an underlying asset, such as a bond or loan. Common types of credit derivatives include credit default swaps, which provide insurance against the default of a borrower, and collateralized debt obligations, which repackage and redistribute credit risk.
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11 Key excerpts on "Credit Derivatives"
eBook - PDFBond and Money Markets
Strategy, Trading, Analysis
- Moorad Choudhry(Author)
- 2003(Publication Date)
- Butterworth-Heinemann(Publisher)
A more rigorous technical approach is contained in Choudhry et al. (2001). . 1029 64 Introduction to Credit Derivatives In this chapter we introduce and review the market in Credit Derivatives, which are a relatively new instrument but have grown in importance fairly rapidly. They are increasingly common instruments, and are closely connected with the global market in corporate debt. Events associated with the Russian bond market in 1998 and subsequent bond market volatility led to a greater emphasis on the reduction and control of credit risk exposure, and credit deri-vatives are one way for banks to manage their credit risk. 64.1 Overview 64.1.1 Introduction The emergence of a market in Credit Derivatives is one of the most important recent developments in financial risk management. Credit Derivatives offer bankers a new way to establish themselves as intermediaries in the credit market. Using financial engineering techniques imported from other derivative markets, banks are busily trans-forming some readily definable blocks of credit risk into the kind of standardised credit-linked securities that inves-tors demand. Credit Derivatives are bilateral financial contracts that transfer credit default risk from one counter-party to another. They represent a natural extension of fixed income (and equity) derivatives in that they isolate and separate the element of credit risk (arguably the largest part of a bank’s risk profile) from other risks, such as market and operational risk. They exist in a variety of forms, perhaps the simplest is the credit default swap 1 which is conceptually similar to an insurance policy taken out against the default of a bond, for which the purchaser of the insurance pays a regular premium.
- Moorad Choudhry(Author)
- 2001(Publication Date)
- Butterworth-Heinemann(Publisher)
et al. (2001).
Passage contains an image 64Introduction to Credit Derivatives
In this chapter we introduce and review the market in Credit Derivatives, which are a relatively new instrument but have grown in importance fairly rapidly. They are increasingly common instruments, and are closely connected with the global market in corporate debt. Events associated with the Russian bond market in 1998 and subsequent bond market volatility led to a greater emphasis on the reduction and control of credit risk exposure, and Credit Derivatives are one way for banks to manage their credit risk.64.1 Overview
64.1.1 Introduction
The emergence of a market in Credit Derivatives is one of the most important recent developments in financial risk management. Credit Derivatives offer bankers a new way to establish themselves as intermediaries in the credit market. Using financial engineering techniques imported from other derivative markets, banks are busily transforming some readily definable blocks of credit risk into the kind of standardised credit-linked securities that investors demand. Credit Derivatives are bilateral financial contracts that transfer credit default risk from one counterparty to another. They represent a natural extension of fixed income (and equity) derivatives in that they isolate and separate the element of credit risk (arguably the largest part of a bank’s risk profile) from other risks, such as market and operational risk. They exist in a variety of forms, perhaps the simplest is the credit default swap 1
eBook - PDF- Moorad Choudhry(Author)
- 2004(Publication Date)
- Butterworth-Heinemann(Publisher)
2 Credit Derivative Instruments: Part I 1 In Chapter 1 we considered the key issues behind credit risk and credit risk management. Banks, other financial institutions and corporates have been able to manage credit risk more efficiently since Credit Derivatives were introduced to the market from 1993. Credit Derivatives isolate credit as a distinct asset class, much like how interest-rate derivatives such as swaps and futures did in the 1980s. This isolation of credit has improved the efficiency of the capital markets, because market participants can now separate the functions of credit origination and credit risk-bearing. Banks have been able to spread their credit risk exposure across the financial system, which arguably reduces systemic risk. They also improve market transparency by making it possible to price specific types of credit risk better. 2 In this chapter, we consider the various unfunded credit derivative instruments. 3 We will go on later to look at various applications of the instruments and their pricing and valua-tion. We begin with some observations on market volumes and participants. 2.1 Credit risk and Credit Derivatives Credit Derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events . A payout under a credit derivative is triggered by a credit event associated with the credit deriva-tive's reference asset or reference entity . As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what con-stitutes a credit event. The principle behind Credit Derivatives is straightforward. Investors desire exposure to non-default-free debt because of the higher returns this offers. How-ever, such exposure brings with it concomitant credit risk.
eBook - PDF- Christian Bluhm, Ludger Overbeck, Christoph Wagner(Authors)
- 2016(Publication Date)
- Chapman and Hall/CRC(Publisher)
Chapter 7 Credit Derivatives Credit Derivatives are instruments that help banks, financial institu-tions, and debt security investors to manage their credit-sensitive in-vestments. Credit Derivatives insure and protect against adverse move-ments in the credit quality of the counterparty or borrower. For ex-ample, if a borrower defaults, the investor will suffer losses on the investment, but the losses can be offset by gains from the credit deriva-tive transaction. One might ask why both banks and investors do not utilize the well-established insurance market for their protection. The major reasons are that Credit Derivatives offer lower transaction cost, quicker payment, and more liquidity. Credit default swaps, for instance, often pay out very soon after the event of default 1 ; in con-trast, insurances take much longer to pay out, and the value of the protection bought may be hard to determine. Finally, as with most fi-nancial derivatives initially invented for hedging, Credit Derivatives can now be traded speculatively. Like other over-the-counter derivative se-curities, Credit Derivatives are privately negotiated financial contracts. These contracts expose the user to operational, counterparty, liquidity, and legal risk. From the viewpoint of quantitative modeling we here are only concerned with counterparty risk . One can think of Credit Derivatives being placed somewhere between traditional credit insur-ance products and financial derivatives. Each of these areas has its own valuation methodology, but neither is wholly satisfactory for pric-ing Credit Derivatives. The insurance techniques make use of historical data, as, e.g., provided by rating agencies, as a basis for valuation (see Chapter 6). This approach assumes that the future will be like the past, and does not take into account market information about credit quality. In contrast, derivative technology employs market information as a basis for valuation.
eBook - ePub- Moorad Choudhry(Author)
- 2012(Publication Date)
- Butterworth-Heinemann(Publisher)
Chapter 2 Credit Derivative Instruments Part I In Chapter 1 we considered the concept of credit risk and credit ratings. Credit Derivatives, introduced in 1993, isolate credit as a distinct asset class, much like how interest-rate derivatives, such as swaps and futures, isolated interest rates in the 1980s. This isolation of credit has improved the efficiency of the capital markets, because market participants can now separate the functions of credit origination and credit-risk bearing. Banks have been able to spread their credit risk exposure across the financial system, which arguably reduces systemic risk. They also improve market transparency by making it possible to price specific types of credit risk better. 1 In this chapter, we consider the various unfunded credit derivative instruments. 2 We will go on later to look at various applications of the instruments and their pricing and valuation. We begin with some observations on market participants and applications. 2.1 Credit Risk and Credit Derivatives Credit Derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. A payout under a credit derivative is triggered by a credit event associated with the credit derivative’s reference asset or reference entity. As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what constitutes a credit event. The principle behind Credit Derivatives is straightforward. Investors desire exposure to non-default-free debt because of the higher returns this offers. However, such exposure brings with it concomitant credit risk. This can be managed with Credit Derivatives. Alternatively, the credit exposure itself can be taken on synthetically if, for instance, there are compelling reasons why a cash market position cannot be established
- Antulio N. Bomfim(Author)
- 2004(Publication Date)
- Academic Press(Publisher)
Part I Credit Derivatives: Definition, Market, Uses 1 . This Page Intentionally Left Blank 1 Credit Derivatives: A Brief Overview In this chapter we discuss some basic concepts regarding credit deriva-tives. We start with a simple definition of what is a credit derivative and then introduce the main types of Credit Derivatives. Some key valuation principles are also highlighted. 1.1 What are Credit Derivatives? Most debt instruments, such as loans extended by banks or corporate bonds held by investors, can be thought of as baskets that could potentially involve several types of risk. For instance, a corporate note that promises to make periodic payments based on a fixed interest rate exposes its holders to interest rate risk. This is the risk that market interest rates will change during the term of the note. For instance, if market interest rates increase, the fixed rate written into the note makes it a less appealing investment in the new interest rate environment. Holders of that note are also exposed to credit risk, or the risk that the note issuer may default on its obligations. There are other types of risk associated with debt instruments, such as liquidity risk, or the risk that one may not be able to sell or buy a given instrument without adversely affecting its price, and prepayment risk, or the risk that investors may be repaid earlier than anticipated and be forced to forego future interest rate payments. 4 1. Credit Derivatives: A Brief Overview Naturally, market forces generally work so that lenders/investors are compensated for taking on all these risks, but it is also true that investors have varying degrees of tolerance for different types of risk. For example, a given bank may feel comfortable with the liquidity and interest rate risk associated with a fixed-rate loan made to XYZ Corp., a hypothetical corporation, especially if it is planning to hold on to the loan, but it may be nervous about the credit risk embedded in the loan.
eBook - ePubManaging Credit Risk
The Great Challenge for Global Financial Markets
- John B. Caouette, Paul Narayanan, Robert Nimmo, Edward I. Altman(Authors)
- 2011(Publication Date)
- Wiley(Publisher)
CHAPTER 21 Credit Derivatives Ah, take the Cash, and let the Credit go, Nor heed the rumble or a distant Drum!—The Rubhaiyat of Omar Khayayam, stanza 13 (translated by Edward FitzGerald)Credit Derivatives are financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or group of issuers. Banks introduced them in the early 1990s to help them deal with their paradoxical desire to enjoy the benefits of asset concentration1 without having to face the attendant risks. Implausible as this may seem at first sight, it has proven possible for banks to resolve this paradox to the benefit of all concerned. The solution required the banks to find counterparties that are willing to assume the credit risk in exchange for a fee, while the bank itself retained the asset on its books. A credit derivative is so named because it is derived from the existence of an underlying asset, for example, a loan. Just as a bank is able to swap the fixed rate on an asset for a floating rate, it can now, by paying a premium, swap the default risk on an asset for the promise of a full or partial payout if the asset defaults. Credit Derivatives can be tailored to lay off any part of the credit risk exposure, amount, recovery rate, and maturity. They can even be constructed for events such as a rating downgrade that do not involve default.The credit derivative market has exploded in the past 10 years. Its development and continuing innovation has transformed both the banking and fixed income markets irrevocably and some feel we are still in the early stages of the growth in this market.
eBook - ePub- Frank J. Fabozzi(Author)
- 2018(Publication Date)
- Wiley(Publisher)
Credit Derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. A payout under a credit derivative is triggered by a credit event. As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what constitutes a credit event.The principle behind Credit Derivatives is straightforward. Investors desire exposure to nondefault-free debt because of the higher returns that this offers. However such exposure brings with it concomitant credit risk. This can be managed with Credit Derivatives. At the same time, the exposure itself can be taken on synthetically if, for instance, there are compelling reasons why a cash market position cannot be established. The flexibility of Credit Derivatives provides users with a number of advantages and as they are over-the-counter (OTC) products, they can be designed to meet specific user requirements.We focus on Credit Derivatives as instruments that may be used to manage risk exposure inherent in a corporate or non-AAA sovereign bond portfolio. They may also be used to manage the credit risk of commercial loan books. The intense competition amongst commercial banks, combined with rapid disintermediation, has meant that banks have been forced to evaluate their lending policy, with a view to improving profitability and return on capital. The use of Credit Derivatives assists banks with restructuring their businesses, because they allow banks to repackage and parcel out credit risk, while retaining assets on balance sheet (when required) and thus maintain client relationships.As the instruments isolate certain aspects of credit risk from the underlying loan or bond and transfer them to another entity, it becomes possible to separate the ownership and management of credit risk from the other features of ownership associated with the assets in question. This means that illiquid assets such as bank loans, and illiquid bonds can have their credit risk exposures transferred; the bank owning the assets can protect against credit loss even if it cannot transfer the assets themselves.
- Antulio N. Bomfim(Author)
- 2015(Publication Date)
- Academic Press(Publisher)
Part I Credit Derivatives: Definition, Market, Uses Passage contains an image
Chapter 1Credit Derivatives
A Brief Overview
Abstract
In this chapter, we discuss some basic concepts regarding Credit Derivatives. We start with a simple definition of what is a credit derivative and then introduce the main types of Credit Derivatives. Some key valuation principles are also highlighted.Keywords Single-name Credit Derivatives Multiname-Credit Derivatives Valuation principles Static replication Counterparty credit riskChapter Outline1.1What Are Credit Derivatives?31.2Potential “Gains from Trade”41.3Types of Credit Derivatives51.3.1 Single-Name Instruments 51.3.2 Multiname Instruments 61.3.3 Credit-Linked Notes 71.3.4 Sovereign vs. Other Reference Entities 81.4Valuation Principles91.4.1 Fundamental Factors 91.4.2 Other Potential Risk Factors 101.4.3 Static Replication vs. Modeling 111.4.4 A Note on Supply, Demand, and Market Frictions 131.5Counterparty Credit Risk (Again)14In this chapter, we discuss some basic concepts regarding Credit Derivatives. We start with a simple definition of what is a credit derivative and then introduce the main types of Credit Derivatives. Some key valuation principles are also highlighted.1.1 What Are Credit Derivatives?
Most debt instruments, such as loans extended by banks or corporate bonds held by investors, can be thought of as baskets that could potentially involve several types of risk. For instance, a corporate note that promises to make periodic payments based on a fixed interest rate exposes its holders to interest rate risk. This is the risk that market interest rates will change during the term of the note. In particular, if market interest rates increase, the fixed rate written into the note makes it a less appealing investment in the new interest rate environment. Holders of that note are also exposed to credit risk, or the risk that the note issuer may default on its obligations. There are other types of risk associated with debt instruments, such as liquidity risk, or the risk that one may not be able to sell or buy a given instrument without adversely affecting its price, and prepayment risk, or the risk that investors may be repaid earlier than anticipated and be forced to forego future interest rate payments.
eBook - PDFCredit Derivatives and Structured Credit
A Guide for Investors
- Richard Bruyere, Rama Cont, Regis Copinot, Loic Fery, Christophe Jaeck, Thomas Spitz, Gabrielle Smart(Authors)
- 2006(Publication Date)
- Wiley(Publisher)
Borrowers know that where a bank no longer holds their risk on its balance sheet, it must inform them under most statutory regulations. That is a point in common with cash securitization transactions (as opposed to synthetic ones). Securitization of bank debts A second technique used by banks to actively manage their loan portfolios is securitization. We shall not go back over this, since it was described in detail in Chapter 4. Credit Derivatives As instruments for managing credit risk, Credit Derivatives have undoubted advantages for banks opting for economic portfolio management policies: They are a relatively simple, flexible and economic method of trading credit risk, and thus enable credit portfolios to be adjusted dynamically. They avoid the constraints inherent to the underlying credit markets: poor liquidity, risk of having to show a loss if an asset is sold, etc. The banks may now take credit positions without having to fund them, since Credit Derivatives are off-balance-sheet instruments. Credit Derivatives enable short positions to be taken on credits, a strategy that is often impossible in the underlying markets where no repo possibilities exist. Finally, they enable leverage positions that cannot be replicated in the cash markets. However, the crucial advantage of Credit Derivatives is the confidential nature of their trans- actions. Traditional banking activity must juggle credit risk-taking with ongoing commercial relationships. To increase exposure to a counterparty, a bank must lend it more money; and once this decision has been taken, its detachment from the debtor takes place gradually, at the rhythm of repayment installments. Credit Derivatives thus offer a confidential (highly prized by banks) way of discreetly jettisoning certain loans without harming the commercial relationship with their best borrowers, who are by definition those to whom they are over-exposed.
eBook - PDF- E. Banks(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
The 2002 credit derivative framework deals with other provisions related to consistent use of guarantees – for example, classic downstream guarantees (qualifying affiliate), upstream or sidestream guarantees (qualifying) – operational standards for notices, more precise definitions of subordination, and so on. Ultimately, regulation must achieve some specific benefit. In a world that is characterized by lower barriers to entry and competitive pressures, DERIVATIVES, CREDIT, AND RISK MANAGEMENT 76 participants must evaluate the nature and extent of proper regulation. If regulation can produce better results than deregulation (or lack of regu- lation) or if it can enhance or strengthen self-oversight, then the process is likely to be beneficial. If some market failure has occurred and requires regulatory repairs that, too, can be beneficial. If, however, regulation is simply imposed to create another layer of rules, then inefficiencies are likely to arise (for example, cost of compliance) and the supposed benefits of the market will start to contract – perhaps even disappear. Regulation and self-regulation must be handled carefully and aim towards the same final goals. 77 REGULATORY AND INDUSTRY INITIATIVES 79 PART II The Credit Risk of Complex Derivatives BACKGROUND As noted in Chapter 3, proper governance and control require a firm to iden- tify, measure, manage, and monitor variables that represent uncertainty or risk to the normal functioning of operations. This is especially true in the financial industry, where the essence of the business is to reward an institu- tion for risks it assumes. The effective management of risks is typically accomplished through a framework that lets an institution control the differ- ent risks inherent in its line of businesses; this allows potential losses to be managed to firmwide tolerance levels and profits to be maximized.
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